What is regulatory risk? Definition and meaning

Regulatory risk refers to the potential negative impact on certain businesses due to a change in the laws and regulations in a country or region. The term is commonly found in articles about currency traders, whose exposure to financial loss is affected by the relevant regulatory agencies when they make changes in current rules and regulations, or impose new ones.

Securities, companies, sectors or markets are exposed to regulatory risk. Certain changes in the laws and regulations made by a regulatory body or the government may push up the cost of operating a business, undermine the attractiveness of certain investments, or change the competitive landscape.

Electricity, butane gas and water companies – utilities – are particularly prone to regulatory risk, simply because government departments and agencies usually monitor them closely and often impose limits on how much they can charge customers, insist on a minimum infrastructure requirement, and generous compensation arrangements for dissatisfied consumers.

Regulatory riskThe pharmaceutical industry is highly exposed to regulatory risk. Politicians like making promises to voters during election campaigns regarding healthcare costs. Would you say that the crowd of people in the image above are members of the general public or pharmaceutical executives?

A nationwide electricity supply company’s expected profits for the next twelve months can be severely damaged if the regulatory body imposes a maximum permissible increase in customers’ electric bills. In the USA, each state has its own utilities commission. Britain’s regulator for public utilities is called Ofgem.

If regulators changed the amount of margin that investment accounts were allowed to have, the effect on that country’s stock market would be considerable, because investors would be forced to either comply with the new margin requirements or dispose of their positions. Fortunately, this type of regulatory risk is tiny.

Politicians interested in regulatory risk

Investors and business people are not the only individuals concerned about regulatory risk. Politicians and legislators also prioritize these concerns, given that new policies can significantly affect important societal factors, such as the national economy or the political landscape.

In fact, even threats of new regulations or policies have consequences.

Peter DiamandisPeter H. Diamandis, a Greek–American engineer, physician,and entrepreneur, best known for being the founder and chairman of the X Prize Foundation, once said: “Many people who try to do big bold things in the world find out it’s not about the money or the technology: It’s about the regulatory hurdles that will try and stop you.” (Image: twitter.com/peterdiamandis)

Regulatory risk is heightened when a new government administration takes office. Speculation, usually by the media, can encourage investors to move their money in other directions or simply sit on their hands and wait. In other words, new investments move elsewhere or dry up.

Even qualified professionals face regulatory risks. A change in the law could mean that people who formerly acted in a certain capacity are no longer authorized to do so.

Post-crisis regulatory risk

Since the global financial crisis of 2007/2008, the regulatory landscape has become considerably more complex. In the advanced economies, supervision and enforcement has become much more confrontational, intensive and intrusive.

Today, regulators make judgments about both the robustness of regulated firms’ business models, and the suitability of the goods they have on sale. If regulators see or anticipate problems, they now intervene straight away.

According to McKinsey & Company:

“Regulatory changes in the financial services industry have come with dizzying speed and complexity, often with massive implications for business models and competitive strategies.”

Laws and regulations are becoming increasingly more detailed, extraterritorial reach is expanding, and the consequences of non-compliance are considerably more severe than ever before. Companies across the world are now reorganizing their lines of defense.

How companies respond to and manage this new regulatory environment will be crucial to their future commercial health.

Regulatory risk management

Regulatory risk management has assumed heightened importance since the global financial crisis and Great Recession that followed it.

While market and credit risk have always featured on senior management’s agenda, external regulatory developments that have focused on greater transparency, capital adequacy, liquidity and consumer protection have triggered businesses to focus on effective risk management frameworks.

The US subprime mortgage crisis, which began in 2007, soon became an international banking crisis.

It exposed serious deficiencies in bank strategies and risk management. The basic business model of financial institutions has changed – today the focus is less on product profitability and more around customer needs.

The new watchword today is financial stability. Gaps detected in regulatory oversight and management are being plugged through more comprehensive frameworks and guidelines.

Financial services companies today face growing regulatory risk as authorities enforce compliance rigorously.

Major banks in North America, the European Union, Japan and Australasia today have to undergo stress tests, where different crisis scenarios are simulated to see how they would cope. Many have failed these tests and have had to further reorganize themselves.

Business professionals specialized in regulatory risk management are highly sought after today.

Regarding regulatory risk management, The National writes:

“It can be said that regulatory risk management depends critically on the value of the data underlying produced records, its analysis and evaluation.”

“Where data quality is inadequate, risk and compliance management lacks a strong foundation. Responsible oversight by senior management and boards requires that these issues are given appropriate attention.”

Video – Mitigating regulatory risk

In this video, Ted Datta, a Director at GRC Solutions (UK & Ireland) explains that in layman’s terms “regulatory risk means non-compliance with legislation – this can lead to fines, damage to reputation, and of course, criminal convictions.”